Unobservable Effort Research Articles

Selective Trials: A Principal-Agent Approach to Randomized Controlled Experiments

We study the design of randomized controlled experiments in environments where outcomes are significantly affected by unobserved effort decisions taken by the subjects (agents). While standard randomized controlled trials (RCTs) are internally consistent, the unobservability of effort provision compromises external validity. We approach trial design as a principal-agent problem and show that natural extensions of RCTs - which we call selective trials - can help improve the external validity of experiments. In particular, selective trials can disentangle the effects of treatment, effort, and the interaction of treatment and effort. Moreover, they can help experimenters identify when measured treatment effects are affected by erroneous beliefs and inappropriate effort provision.

Determinants of the Importance of Signals on Ability in the Presence of Adverse Selection

This paper analyzes the tradeoffs associated with relying on performance versus ability measures in executive compensation. We propose a principal-agent model in which the principal designs the compensation scheme to be contingent on the outcome of interest to the principal along with a noisy signal of the agent’s ability. The outcome depends on managerial effort and ability. The signal of ability may include traditional measures of human capital, as well as information gleaned from private interactions with the agent. We consider two information structures: pure adverse selection (unobservable ability), and the scenario with moral hazard and adverse selection (unobservable effort and ability). In each information structure, we determine the conditions under which the principal places positive or negative weights on the outcome and signal of ability; when the principal relies more heavily on the outcome relative to the signal of ability; and relate our findings to the adjusted sensitivity results in Banker and Datar (1989). Finally, we compare the weights placed on the outcome and signal of ability across the two information structures, to determine the implications of introducing moral hazard.

The Compensation of University Presidents: A Principal-Agent Theory and Empirical Evidence

This paper proposes an agency model with moral hazard and adverse selection of the relationship between a university and its president, and constructs a unique dataset to examine the determinants of the compensation of university presidents. In our model, the outcome of interest to the university depends on the unobservable effort and ability of the president, along with a signal of the president’s fit for the position that is unobservable to researchers. We postulate four hypotheses on the basis of our analytical model. First, a president with favorable personality traits is more adept at leading a complex university, so her compensation is increasing in the university’s complexity (stature). Second, due to adverse selection, the president’s compensation is increasing in her ability. Third, for a president with a prior presidency, the stature and size of her past university has a positive effect on her present compensation, since those are signals of ability. Fourth, research-oriented universities offer greater compensation to high ability presidents, due to complementarity between research-related tasks and ability. We collect a sample drawn from 279 private universities spanning the period 2001-2006, yielding a total of 1,011 university-year observations. Using four measures of the university’s stature and five measures of the president’s ability, we find strong support for our first three hypotheses, and obtain mixed results for the fourth hypothesis.

On the design of coordinating contracts

We concentrate on a principal and agent system often seen in supply chain management studies. Under reasonable conditions, we show that a nearly systematic three-step method can be used to find coordination contracts for the system. The number of terms involved in our contract is in some sense positively correlated with the degree of information asymmetry between the principal and agent. Several known contract types for the supplier–retailer newsvendor system can be viewed as special cases resulting from applications of this method. Following our three-step approach, we succeed in identifying coordinating contracts for a supply chain involving two products and unobservable retailer efforts.

Private Equity Fund Returns and Performance Persistence

Successful private equity managers have funds that are often oversubscribed and provide persistent abnormal returns. Why don't successful managers increase fund size or fees? We argue that managers want to attract high quality entrepreneurs, while entrepreneurs want to match with high ability managers. However, observing fund performance does not allow entrepreneurs to distinguish a manager's ability from the quality of firms in the fund's portfolio. As a consequence, a fund manager may devote unobserved effort to select firms, and keep fund size small to limit the cost of effort, hoping to manipulate entrepreneurs' beliefs about his ability.

Leveraged Buy Out: Dynamic Agency Model with Write-Off Option

We present a dynamic agency model in which the LBO fund may write the entrepreneur's project off at the end of the starting stage to invest in a competitive project. The two partners provide unobservable efforts in both stages to enhance the productivity of the acquired company. We show that under restrictive conditions, the debt-equity contracts induce the entrepreneur and the LBO fund to provide the first best efforts under restrictive conditions in the two stages. Moreover, the write-off threat boosts the incentives of the entrepreneur and the LBO fund such that they provide high efforts. If the compensation cost is exogenous, the sharing rule of this cost depends on the quality of the competitive project. The entrepreneur and the bank share the amount of compensation if it is not very profitable. Otherwise, it is pledged to the entrepreneur. If the compensation's amount is endogenous, in order to induce the entrepreneur to provide high effort, the optimal financial contracts must give her the entire compensation's revenue.

A moral solution to the moral hazard problem

In agency theory, offering a flat salary contract under unobservable effort creates a moral hazard problem because the agent is motivated to shirk and provide less than a previously agreed-upon level of effort. We examine a moral solution to this moral hazard problem. In particular, we present a principal-agent model where the agent possesses some level of moral sensitivity that causes him disutility if he provides less than the agreed-upon level of effort. We examine the interplay between moral sensitivity and firm productivity in determining the optimal salary contract, and contrast our moral solution with the traditional incentive solution that becomes necessary when moral sensitivity is assumed to be zero. This allows us to highlight the benefits of the agent’s moral sensitivity to both the principal and the agent, and thereby, point out the potential cost of ignoring this moral sensitivity. We conclude that adding moral sensitivity increases the descriptive, prescriptive, and pedagogical usefulness of the principal-agent model.

Information Sharing in Common Agency: When is Transparency Good?

When should principals dealing with a common agent share their individual performance measures about the agent’s unobservable effort for producing a public good? In a model with two principals who offer linear incentive schemes, we show that information sharing always increases total expected welfare if the principal who is less informed about the agent’s effort also cares more about the agent’s output. If the less informed principal cares somewhat (but not too much) less than the other principal about the agent’s output, information sharing reduces total expected welfare. In our model the efficient information regime emerges as an equilibrium outcome.

The Theory of Incentives Applied to the Transport Sector

Building upon Iossa and Martimort (2008), we study the main incentive issues and the form of optimal contracts for Public Private Partnerships (PPPs) in transports. We present a basic model of procurement in a multitask environment in which a risk-averse firm chooses unobservable efforts in infrastructure and service quality. We begin by analyzing the effect on incentives and risk transfer of bunding building and operation into a single contract. We consider the factors that affect the optimal allocation of demand risk and their implications for the choice of contract length. We discuss the dynamics of PPP contracts and how the risk of regulatory opportunism affects design and incentives.

Wealth constraint and contractual arrangements

Abstract We examine how a project owner optimally selects a project operator and motivates him to deliver an unobservable effort when potential operators are wealth constrained. We show that, when potential operators' abilities are common knowledge, an operator's share of realized profit can be increasing, invariant, or decreasing in his ability depending on the nature of production technology. However, when potential operators are privately informed about both their abilities and their effort supply, a bunching contract arises in equilibrium for a general class of production technology. In the case of bunching, all potential operators are selected equally often and awarded an equal share of realized profit. The finding provides an explanation for the relative uniformity of contract terms in many practical settings.

Efficiency in complementary partnerships with competition

AbstractThe objective of this paper is to show how efficiency can be implemented in a market with strictly complementary inputs when the productive firms undertake unobservable effort. The observable output is a joint undertaking by a partnership consisting of two types of firms. It is shown that simple linear sharing rules cannot implement socially optimal effort, but a modified linear sharing rule can implement the first‐best outcome provided that commitment to the proposed sharing rule is possible. This is so even when the sharing rule is proposed by one of the active partners. When opening up for the possibility of renegotiating sharing contracts that have undesirable properties for one or more of the firms, it becomes more difficult to implement socially efficient solutions. Implementation of the socially efficient outcome requires that the sharing rule is proposed by an outsider to the partnership. Copyright © 2008 John Wiley & Sons, Ltd.

A Continuous-Time Version of the Principal–Agent Problem

This paper describes a new continuous-time principal–agent model, in which the output is a diffusion process with drift determined by the agent’s unobserved effort. The risk-averse agent receives consumption continuously. The optimal contract, based on the agent’s continuation value as a state variable, is computed by a new method using a differential equation. During employment, the output path stochastically drives the agent’s continuation value until it reaches a point that triggers retirement, quitting, replacement, or promotion. The paper explores how the dynamics of the agent’s wages and effort, as well as the optimal mix of short-term and long-term incentives, depend on the contractual environment. The understanding of dynamic incentives is central in economics. How do companies motivate their workers through piece rates, bonuses, and promotions? How is income inequality connected with productivity, investment, and economic growth? How do financial contracts and capital structure give incentives to the managers of a corporation? The methods and results of this paper provide important insights to many such questions. This paper introduces a continuous-time principal–agent model that focuses on the dynamic properties of optimal incentive provision. We identify factors that make the agent’s wages increase or decrease over time. We examine the degree to which current and future outcomes motivate the agent. We provide conditions under which the agent eventually reaches retirement in the optimal contract. We also investigate how the costs of creating incentives and the dynamic properties of the optimal contract depend on the contractual environment: the agent’s outside options, the difficulty of replacing the agent, and the opportunities for promotion. Our new dynamic insights are possible due to the technical advantages of continuous-time methods over the traditional discrete-time ones. Continuous time leads to a much simpler computational procedure to find the optimal contract by solving an ordinary differential equation. This equation highlights the factors that determine optimal consumption and effort. The dynamics of the agent’s career path are naturally described by the drift and volatility of the agent’s pay-offs. The geometry of solutions to the differential equation allows for easy comparisons to see how the agent’s wages, effort, and incentives depend on the contractual environment. Finally, continuous time highlights many essential features of the optimal contract, including the agent’s eventual retirement. In our benchmark model a risk-averse agent is tied to a risk-neutral principal forever after employment starts. The agent influences output by his continuous unobservable effort input. The principal sees only the output: a Brownian motion with a drift that depends on the agent’s effort. The agent dislikes effort and enjoys consumption. We assume that the agent’s utility function has the income effect, that is, as the agent’s income increases it becomes costlier to compensate him for the effort. Also, we assume that the agent’s utility of consumption is bounded from below.

The cost of imperfect agency in health care: Evidence from rural Cameroun

Health is a pressing problem facing Africans today, yet health care systems in Africa are inadequate and under-funded. We show that pervasive imperfect agency means that they are also inefficient. Imperfect agency (due to unobservable medical effort) is a recognized market failure in health care, but its impact is difficult to measure. We take an indirect approach to estimation and infer the cost of unobservable effort from the behavior of utility-maximizing patients, specifically their willingness to incur measurable costs to avoid practitioners who shirk. We use a unique data set from rural Cameroun where patients choose between the government health system, church-operated (mission) health facilities and, importantly, traditional healers. Traditional healers provide health services on an outcome–contingent basis where patients pay only if they are cured. Both government and mission facilities, in contrast, are paid on a fee-for-service basis. Patients' choices of practitioners, combined with quantitative information about patients' illnesses, permit a structural estimation of the value of unobservable medical effort. The results allow investigation into the nature of agency, its costs, and the manner in which contracts reduce and patient behavior mitigates those costs. We estimate that in the absence of imperfect agency, utility from health care would increase by at least 160%. Even in the face of imperfect agency, the sophistication of patients in choosing between existing contracts for different illnesses increases utility by up to 20%.

Importance of Measures of Past Performance: Empirical Evidence on Quality of e‐Service Providers*

There has been considerable interest in the management accounting research literature in studying how managerial and worker compensation depends on measures of their performance. Stemming from the theoretical analysis of Holmstrom 1982, Banker and Datar 1989, and others, several empirical studies have sought to examine the implicit role and impact of different performance measures (e.g., Antle and Smith 1986; Lambert and Larcker 1987; Bushman, Indjejikian, and Smith 1996; Ittner, Larcker, and Rajan 1997; Banker, Potter, and Srinivasan 2000). Since the economic theory motivating this research stems from a model of moral hazard with unobservable effort from the agent, the only performance measures that appear relevant are those whose distributions are shifted by the agent’s choice of effort level. As a result, the focus of past research has been on measures of future performance that are contingent on agent’s effort. In this paper, we focus on the role of measures of past performance and accomplishments in determining compensation for services provided. Measures of past performance we consider in this study are observable by both the principal and the agent, and differ from the predecision precontract information in Baiman and Evans 1983 that is available only to the agent. Past performance in our study provides a signal on the intrinsic ability or quality of a service provider. In an adverse selection setting where the service provider’s intrinsic ability is not observed directly by the purchaser of the service, measures of past performance and accomplishments are likely to be informative (Darrough and Melumad 1995). The compensation paid for the service, therefore, is likely to depend on the past performance and other signals on the provider’s ability to deliver valuable service. Murphy and Zabojnik (2003), for example, find that as large corporations now tend to hire chief executive officers (CEOs) externally rather than through internal promotions, transferable skills are more important than firm-specific skills. As a

Optimal unemployment policy in a matching equilibrium

This paper considers optimal unemployment policy in a matching equilibrium with risk averse workers and unobserved job search effort. The Planner chooses unemployment benefits, taxes and job creation subsidies to maximise a Utilitarian welfare function. Optimal policy involves a trade-off between higher employment taxes (which finance more generous unemployment benefits) and greater market tightness (which reduces the average unemployment spell). Optimal UI implies the initial UI payment equals the wage, thus ensuring consumption is smooth across the job destruction shock, and UI payments then fall with duration.

Attracting responsible employees: Green production as labor market screening

Corporate social responsibility can improve firms’ ability to recruit highly motivated employees. This can secure socially responsible firms’ survival even in a highly competitive environment. We show that if both socially responsible (green) and non-responsible (brown) firms exist in equilibrium, workers with high moral motivation, who shirk less than others, will self-select into the green firms. If unobservable effort is sufficiently important for firm productivity, this can drive every brown firm out of business—even in the case where many workers have no moral motivation whatsoever.

On the Use of Loose Monitoring and Lavish Pay in Agency

In this paper, we study a setting where a firm (principal) is privately informed of the firm's potential and contracts with an agent to supply unobservable effort. We show it can be optimal for the firm to have loose monitoring in the sense that the monitoring system is less perfect than what is implied by a standard agency model a la Holmstrom (1979) and to provide lavish pay in the sense that the optimal contract provides the agent with higher expected utility than his reservation level. These two tools are used to achieve separation among different types of firms such that firms with low potential do not have incentives to mimic contracts offered by high potential firms. Our findings imply that although loose monitoring and lavish compensation offered to employees may be symptoms of firms squandering scarce resources provided by investors, they can also arise as an optimal contracting arrangement.

A Moral Solution to the Moral Hazard Problem

In agency theory, offering a flat salary contract under unobservable effort creates a moral hazard problem because the agent is motivated to shirk and provide less than a previously agreed-upon level of effort. We examine a moral solution to this moral hazard problem. In particular, we present a principal-agent model where the agent possesses some level of moral sensitivity that causes him disutility if he provides less than the agreed-upon level of effort. We examine the interplay between moral sensitivity and firm productivity in determining the optimal salary contract, and contrast our moral solution with the traditional incentive solution that becomes necessary when moral sensitivity is assumed to be zero. This allows us to highlight the benefits of the agent's moral sensitivity to both the principal and the agent, and thereby, point out the potential cost of ignoring this moral sensitivity. We conclude that adding moral sensitivity increases the descriptive, prescriptive, and pedagogical usefulness of the principal-agent model.

Am I Missing Something? The Effects of Absence from Class on Student Performance

We exploit a rich administrative panel data-set for cohorts of Economics students at a UK university in order to identify causal effects of class absence on student performance. We utilise the panel properties of the data to control for unobserved heterogeneity across students and hence for endogeneity between absence and academic performance of students stemming from the likely influence of unobserved effort and ability on both absence and performance. Our estimations also exploit features of the data such as the random assignment of students to classes and information on the timetable of classes, which yield potential instruments in our identification strategy. Among other results, we find that there is a causal effect of absence on performance for students: missing class leads to poorer performance. There is evidence from a quantile regression specification that this is particularly true for better-performing students, consistent with our hypothesis that effects of absence on performance are likely to vary with factors such as student ability.

The Organizational Dimensions of Creativity: Motion Picture Production

Internal or contractual production of highly creative products requires managers to assess both unobservable effort and uncertain output, leading to lack of cost control. Similarly, in procuring creative products in the marketplace, managers face the unavoidable winner's curse risk. Since this risk is, to a large extent, independent of the creative nature of the product, the higher the creative content, the higher the relative hazards associated with internal or contractual production. Thus, internal/contractual production of creative goods will tend to be less prevalent the higher the creative content associated with its production. The evolution of the U.S. film industry in the mid-20th century provides examples and implications for managing highly creative activities and ventures.